Non-U.S. Banks Stock Update – Nov. 2010

The global banking industry has been recovering at a slow pace from the worst financial crisis that started as a credit issue in the subprime segment of the U.S. mortgage market in mid-2007 and spilled over to Europe and other economies. Though the worst of the financial crisis is behind us, there remain major challenges following the intervention of governments to rescue and stabilize the global banking system.

Although non-U.S. banks are still dealing with liquidity and confidence challenges, governments have taken several steps to alleviate the sector, as banks are the lifeblood of the economy. Consequently, political interference in the sector has increased significantly over time, which has added to existing financial risks.

Politics will continue to influence the banks’ lending decisions until they repay the government money. According to banking regulators, if governments withdraw their support from banks before giving them sufficient time to restore their financial strength, the sector could face another collapse.

Though the industry is in the process of adopting tougher measures to help prevent a recurrence of the global financial crisis and restore public confidence, concerns remain. However, we believe this would be the perfect time to consider non-U.S. bank stocks for mid- to long-term investments, as valuations are now comparatively cheap.

Investors with short-term targets, however, should be very careful of choosing non-U.S. stocks at this point as near-term fundamentals remain weak; asset quality is not expected to improve anytime soon as default rates for individuals and companies are not expected to materially subside, and revenue growth is expected to remain weak as loan growth falters and investment banking faces a dearth of business despite the economic recovery.

Though high unemployment and sluggish business conditions worldwide are expected to dampen demand for credit, banks are now capable of lending more. Despite top-line pressure due to a sluggish economic recovery, the mid- to long-term outlook for non-U.S. banks remains encouraging, given the stability of loan growth, accelerated consumer lending and improving deposit growth.

Although the upturn in the banking sector through the first half of 2011 will vary from country to country, depending on industry circumstances, we believe that banks in emerging economies − Chile, Brazil or India, for instance − may be more attractive investments, similar to what we expect for certain regional banks in the U.S.

The same, however, cannot be said of European institutions. Earlier this year, the debt crisis originating in the Greek economy threatened the stability of the European Union’s (EU) monetary policies. Starting as a solvency crisis in a single country, the turmoil threatened the entire Euro zone. Though Greece adopted measures to minimize government spending and stress test results were largely reassuring, there is no guarantee that the country is out of the woods as affluent domestic and foreign investors will not stop withdrawing their money from Greek banks anytime soon.

The European Union is taking further action to restore the confidence of investors and the health of the European banking system, but the issue is far from fully addressed. This is evident from issues related to the Irish banking system and that government’s refusal to ask from help from the IMF and/or the EU.

To be sure, banks in emerging economies will face asset quality issues. However, they are not plagued by other significant problems that many of the larger banks face in continental Europe and the United Kingdom, such as toxic securities, dilution from capital raising and dividend cuts/omissions. Moreover, these emerging-market banks generally tend to be well capitalized, aren’t as heavily exposed to property markets, and have significant and generally growing sources of non-interest income.

The Institute of International Finance, which represents major financial institutions in 70 countries, said in a report recently that firms are learning from the crisis. Banks in emerging economies have performed remarkably well over the last few months to serve as a stabilizing force in global economic recovery.

In all, a key determinant for quick recovery will be the quality of risk analysis and how well risk-awareness is built into decision-making and incentive policies. So we believe that accumulating larger capital buffers over the cycle and reducing pointless complexity in business will be crucial for the performance of non-U.S. banks. Also, the primary attention of policymakers should be to determine how much longer the fiscal stimulus should continue, which should not be withdrawn before a clearer sign of economic recovery is visible.

We also like HDFC Bank Limited (HDB) in India. It has recently been emphasizing strong cost controls and improved operating efficiency, rather than growth, as key strategies. As a result, it has been able to stave some of the earnings pressure off higher loss provisions due to a weakening asset quality.

We would suggest avoiding banks in Greece at this point. Also, it is better to avoid banks in Great Britain and Ireland, particularly those that have participated in government recapitalization programs and have yet to repay the money. In return for government capital and asset quality protection, these banks are facing government intervention, including limits on dividend payouts and the nomination of board members.

Based on gradually stabilizing fundamentals, the industry has been experiencing positive estimate revisions in the recent months. This reflects improving profitability outlook for non-U.S. banks over the mid to long term.

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